


University of Texas Bulletin 

No. 1905: January 20, 1919 



Some Dangers in Establishing a Pension 
System and the Proper Precautions 



BY 
Edtvard L. Dodd 




rUBUSHBD BY 

THE UNIVERSITY OF TEXAS 

AUSTIN 



Publications of the University of Texas 

Publications Committee: 

F. W. Graff R. H. Griffith 

G. C. Butte J. L. Henderson 
D. B. Casteel E. J. Mathews 
Frederic Duncalf C. E. Rowe 

The University publishes bulletins six times a month, so 
numbered that the first two digits of the number show the 
year of issue ; the last two tho position in the yearly series. 
(For example, No. 1701 is the first bulletin of the year 1917.) 
These comprise the official publications of the University, 
publications on humanistic and scientific subjects, bulletins 
prepared by the Department of Extension and by the Bureau 
of Municipal Research and Reference, and other bulletins 
of general educational interest. With the exception of 
special numbers, any bulletin vdll be sent to a citizen of 
Texas free on request. All communications about Univer- 
sity publications should be addressed to the Chairman of 
the Publications Committee, University of Texas, Austin. 



598-3399-1219-lm 



University of Texas Bulletin 

No. 1905: January 20, 1919 



Some Dangers in Establishing a Pension 
System and the Proper Precautions 



BY 
Edward L. Dodd 




PUBLISHED BY THE UNIVERSITY SIX TIMES A MONTH, AND ENTERED AS 

SECOND-CLASS MATTER AT THE POSTOFFICE AT AUSTIN. TEXAS. 

UNDER THE ACT OF AUGUST 24, 1912 



v^'-p. 



The benefits of education and of 
useful knowledge, generally diffused 
through a community, are essential 
to the preservation of a free govern- 
ment. 

Sam Houston 



Cultivated mind is the guardian 

genius of democracy It is the 

only dictator that freemen acknowl- 
edge and the only security that free- 
men desire. 

Mirabeau B. Lamar 



Ts: of t; 

FE3 23 1920 



CONTENTS 

1. Introduction. The need of an adequate pension 

fund. Dangers of failure and of exorbitant 
cost 5 

2. A sound pension system. The system of the 

Teachers Insurance and Annuity Association 6 

3. The nature of a pension. A portion of salary with 

payment postponed 7 

4. Unfair and insolvent pension systems. Forfeitures 

by death and withdrawal. The loss of interest 
accumulations 8 

5. Inferences from population tables. The burden of 

a system paying pensions out of current funds 11 

6. Preliminary computations in establishing a pension 

fund. Retroactive increases of salary paral- 
leled by equivalent increases in future salaries. 
Four cases depending upon the cost of living. 
Some books on compound interest, insurance, 
and pensions (annuities) 13 

7. The creation and investment of the pension fund. 

The danger in creating a pension fund by in- 
stallments. The accrued liability created by 
pension contracts 20 

8. Pensions obtainable through insurance. The pur- 

chase of pensions by endowments and cash 
values. Total disability benefits giving com- 
plete protection 22 

9. Enquiries preliminary to the establishment of a 

pension system. The need of pensions. Va- 
rious options and forms of investment 23 

10. Conclusion. The need of a reserve fund 25 



SOME DANGERS IN ESTABLISHING A PENSION 
SYSTEM AND THE PROPER PRECAUTIONS 

§1. Introduction 

There is no doubt that pensions have played an import- 
ant part in alleviating hardships. This is true, also, of life 
insurance. It is not surprising, then, that the great need 
of protection has called into existence many distinct forma 
of insurance and pensions, of which some are unscientific 
and have proved disastrous, either failing to give the pro- 
tection ivhen most needed or giving it at an exorbitant cost. 

Many are familiar with the unfortunate results that have 
usually attended assessment insurance, but are perhaps un- 
aware of the similarity of assessment assurance to certain 
common pension systems. 

Assessment companies are distinguished from "legal re- 
serve" companies by the fact that the former carry no ade- 
quate "reserve" funds by which they can guarantee the 
performance of their contracts. This so-called "reserve" 
is not surplus, but is a fund to cover acc7'ued liabilities. 
Some assessment companies, it is true, have met all just 
demands upon them ; but very many have failed. And some 
assessment companies have funds called "reserves," which 
are decidedly inadequate. 

An assessment company may be described as an organi- 
zation in which one generation pays the insurance claims 
of a former generation and hopes to receive like treatment 
from the following generation, although a material guar- 
antee is lacking. Here a generation is thought of as de- 
termined by priority of death rather than of birth. 

The chief defect of some pension systems is the lack of 
an adequate reserve. As in assessment insurance, this lack 
of adequate reserve creates some danger that the promises 
or contracts for pensions will not be kept or performed. 
If, furthermore, the proper precautions are not taken in 
the establishment of the pension system, there is a much 



6 University of Texas Bulletin 

greater danger that the younger generation and all future 
generations tuill pay for their pensions, ifidirectly through 
postponed promotions, double the market value of their pen- 
sio7is. The explanation of this will appear in Section 4. 

§ 2. A Sound Pension System 

Before investigating in detail the defects of certain pen- 
sion systems, it may be well to describe very briefly, as one 
example of a pension system on a sound basis, the plan 
of the Teachers Insurance and Annuity Association of 
America, "organized at the instance of the Carnegie Found- 
ation for the Advancement of Teaching* ... Its capital and 
surplus were provided by the Carnegie Corporation of New 
York . . . The purpose of the corporation is to provide insur- 
ance and annuities for teachers and other persons employed 
by colleges, by universities, or by institutions engaged pri- 
marily in educational or research work . . . Through an en- 
dowment, contributed in the form of capital and surplus, 
it is able to offer insurance at cost." 

The following are the chief features of the pension plan : 

1. The monthly or periodical payment by the teacher 
to the company of a specified sum of money — this sum to 
be increased at pleasure within reasonable limits. 

2. The investment of all such payments at a guaranteed 
four per cent compound interest, credited to the teacher 
individually. 

3. (a) The use of the entire accumulation of a teacher 
between the ages of 60 and 70 to purchase a pension — 
continued in reduced amount to the widow of a teacher, 
if so desired — at an equitable price in accordance with the 
standard annuitant mortality table (McClintock's), with 
four per cent interest allowed; or 

3. (b) In case of death, the delivery of the entire ac- 
cumulation to the beneficiary or to the estate of the deceased 
teacher, 

4. The . retention by the teacher withdrawing from a 



*Handbook of the company, pp. 3, 4 (1918 edition), 



Dangers in Establishing Pension Systems 7 

university of his interest in the pension fund. If he teaches 
elsewhere, his status is unchanged; if he leaves the pro- 
fession, his premiums thereafter are increased by one-ninth 
to secure the same benefit. 

The company suggests, indeed, that a teacher pay five 
per cent of his salary and that his college pay an additional 
five per cent to be accumulated for his pension. Thus, a 
teacher with a salary of $200 monthly would pay $10 
monthly, and his college would also pay $10 monthly. This 
suggestion, if carried out, would virtually raise the salary 
of the teacher from $200 to $210 ; of this, $190 would be 
available for immediate use, and $20 would be set aside 
at four per cent interest to buy ultimately the pension. 
This suggestion is not an essential feature of the pension 
system, though it may commend itself to many. 

It will be noticed that this system appears not to make 
adequate provision for the older men for whom the period 
of accumulation will be short. But an equitable adaptation 
for making such provision, whether the pension reserve is 
held by the college itself or by an insurance company, will 
be explained in Section 6. Again, it may appear to some 
unfair to make men who leave the teaching profession pay 
a larger price for the benefit to be received. But this pro- 
vision would affect only a small percentage of college teach- 
ers; and it is a consistent policy for a company organized 
for the special benefit of teachers. 

The pension system of the Teachei^s Insurance and An- 
nuity Association is both sound and just. The system is 
sound, because a pension becomes payable only after the 
proper rese7''ve fund for it has been accumulated. 

§ 3. The Nature of A Pension 

When a pension system is first established, it frequently 
happens that some teachers or employees receive the pen- 
sions without having anticipated them. A pension is likely 
to seem a great boon which sometimes comes to employees 
in addition to their normal compensation. A careful an- 



8 University of Texas Bulletin 

alysis of the situation, however, will show that a pension 
is simply a portion of salary of which the payment has 
been deferred. Even the payments to those who be- 
come pensioners immediately may best be regarded as the 
equivalent of a retroactive increase of former salaries. 
After a pension system has been in existence for a consid- 
erable time, it becomes still more obvious that a pension 
is simply deferred salary. A college or corporation which 
has a payroll of $300,000 for active men and $60,000 for 
pensioners could equally well pay $360,000 to its active 
men if no pension system had been established. In this 
case the man actually on a $3,000 salary could be drawing 
$3,600, were it not for the pension system; the man on a 
$2,000 salary could be drawing $2,400. A pension is post- 
poned pay. 

§ 4. Unfair and Insolvent Pension Systems 

It is not very difficult for an actuary to determine whether 
a given pension system is solvent or insolvent, whether or 
not adequate financial provision has been made for the per- 
formance of contracts. 

But whether a feature of a pension system is just or 
unjust, fair or unfair, is largely a matter of opinion. The 
standards of fairness in pension systems may be subject 
to progressive improvement, as has been the case in life 
insurance. 

The modern life insurance policy of a reputable legal 
reserve insurance company is a marvel for its comprehen- 
sive fairness. This is due in part to the efforts of con- 
scientious employees in state insurance departments; in 
part to the efforts of far-seeing executives in insurance 
companies who know that fairness wins confidence, and 
pays in the long run. In the earlier days of life insurance, 
there were many forfeits, many schemes for avoiding claims, 
and for getting rid of policyholders after a large share 
of their savings had been absorbed. The modern policy, 
with its non-forfeiture provisions, admirably protects the 



Dangers in Establishing Pension Systeons 9 

insured in his interest in the fund which his premiums have 
created, 

1. Is a pension system unfair if no provision is made 
for an employee who leaves before pensions are payable? 
Whatever be the system of bookkeeping- used, this em- 
ployee's salary has been less than it might have been for 
a number of years, on account of the pension system. Upon 
voluntary or involuntary withdrawal, there is a financial 
forfeiture. Is the forfeiture fair? 

One view of fairness, perhaps, makes fair any contract 
which is thoroughly understood by both parties in advance. 
The modern insurance contract, however, embodies a much 
higher standard of fairness. 

The effect of such a pension provision upon the college 
using it can only be conjectured. Prominent scholars, rec- 
ognizing that a change from one university to another is 
sometimes desirable, may hesitate to accept positions in a 
university which, as they view it, may confiscate part of 
their salary. 

Concerning the "Teachers Retirement Plan," the Teachers 
Insurance and Annuity Association states on page 35 of its 
Handbook: "From the moment the first premium is paid 
on such a policy, the teacher will become the owner of a 
policy or contract which neither his employer nor the As- 
sociation will have any power to modify adversely to his 
interests, and no change of employment or failure to con- 
tinue the payment of premiums can deprive him of the full 
benefit purchased by the premiums already paid," 

2, Is a pension system unfair if no provision is made 
for the family or estate of an employee who dies before 
reaching the age when pensions are payable? Often the 
salary of a teacher in his earlier years of teaching is not 
adequate to permit his carrying much insurance; some- 
times he is not insurable. Upon his death, his family suf- 
fers the loss of the breadwinner; and, furthermore, virtual 
contributions from his past salary, which have been made 
monthly to maintain the pension system, are sacrificed. Is 
this fair? 



10 University of Texas Bulletin 

At one time, deferred dividends in life insurance policies 
were in favor; the periods of deferment were sometimes 
long. If the insured lived a long time, he received a large 
bonus made up from the losses of his comrades who died and 
received no dividends. This form of policy can be made 
mathematically sound. But many have thought it savored 
too much of the. spirit of gambling. In the United States, 
the deferred dividend has, in general, come into disrepute. 
But this deferred dividend partakes of the element of fair- 
ness much more than a provision by which contributions, 
direct or indirect, to a pension fund are forfeited by death ; 
for, even with deferred dividends, the estate of the deceased 
gets the main benefit, the insurance itself. 

3. Is a pension system unfair if it removes from an em- 
ployee's salary, in preparing for his pension, twice as much 
as would be needed to purchase the same pension from an 
insurance company? When preparation is made for a pen- 
sion as suggested by the Teachers Insurance and Annuity 
Association, the teacher's contributions are invested for him 
at a guaranteed four per cent compound interest, and the 
amount finally available for pensions is much greater than 
that actually contributed. But, if pensions are paid out of 
current funds, there are no interest accumulations. Each 
generation after the first and perhaps the second virtually 
pays the pensions of the preceding generation or genera- 
tions — salaries being less than they might have been on ac- 
count of the pension system. Now $100 at four per cent 
compound interest for 18 years amounts to $202.58; for 
35 years, the amount is $394.61 — nearly $400. In the 
Handbook of the Teachers Insurance and Annuity Associa- 
tion, on page 39, the case of a teacher is considered whose 
salary at age of entry 30 is $150 monthly and at age of re- 
tirement 65 is $300 monthly; and contributions of 10 per 
cent of salary are made to the pension fund. The first 
contribution of $15 amounts to about $60 after 35 years; 
this added to the last contribution of $30 makes $90, which 
is double the initial value of this pair of contributions. 
Likewise, if the second contribution is paired with the next 



Dangers in Establishing Pension Systems 11 

to last contribution the amount of this pair is about double 
its initial value. The middle payments bear interest for 
about 18 years and are about doubled. 

In the illustration in the Handbook, the monthly salary 
is raised $50 at ages 35, 45, and 55. The total contribu- 
tion until the close of age 64 is $9,900, and the accumulated 
value of this contribution is given on page 41 as $19,541. 
The contributions in their total have been about doubled by 
compound interest. But this is not all. The price to be 
paid for the pension allows interest at four per cent. Thus 
the men of age 65 get on the average in pensions about 25 
per cent or 35 per cent more than the purchase price. The 
scale of salaries, indeed, and the rate of advancement is 
different in different institutions. But it seems sufficiently 
conservative to say that, if a teacher is denied the benefit 
of compound interest accumulations, he will in general pay 
for his pension double what it is worth. 

§ 5. Inferences from Population Tables 

For certain actuarial purposes, so-called population ta- 
iDles are formed from mortality tables. These give the ex- 
pected distribution of ages among a group of men, when 
that group is kept up by a constant number of entrants of 
specified age each year. A man is supposed to leave the 
:group by death only: there is no migration. 

Suppose that the faculty of a college is kept up by the 
;annual election of a fixed number of new instructors at 
about age 28. If an instructor withdraws, his position is 
to be filled by a man of about equal age ; and the combined 
pension claims of the successor and his predecessor are to 
l)e the same as those of one man filling the position con- 
tinuously. If an instructor dies, his pension claims are to 
he forfeited. Pensions paid out of current funds begin at 
age 65, and are about equal to the average salary received 
in active service; and the total fund available for salaries 
;and pensions does not increase more rapidly than the cost 
"of living. Under these hypotheses, in accordance with 



12 University of Texas Bulletin 

standard population tables, the number of pensioners would 
be about one-fifth the number of active faculty members;, 
it would form about one-sixth the total. If the average- 
salary paid to pensioners is equal to the average salary paid 
to active faculty members, then the pension budget is about 
one-fifth the active budget. Thus, were it not for the pen- 
sion budget, each active faculty member could be assigned, 
a salary increase of 20 per cent. For this kind of pension 
system, giving no benefits to the estate of deceased faculty 
members, a man relinquishes about one-sixth of his possible 
salary. But for only about one-eighth of his salary, when, 
the contributions are deposited with the Teachers Insur- 
ance and Annuity Association, he can provide for the same 
pension benefit and in addition for the return to his family,, 
in case of death, of his contributions with four per cent; 
compound interest (See Handbook, pages 39, 40). 

This return of contributions to the family of the deceased, 
is worthy of some consideration; for of 100 men of age 2& 
about 43 die before reaching the age 65, by the American 
Experience Mortality Table. 

For a growing institution paying pensions out of current 
funds in the above manner, the pension burden would nor- 
mally be somewhat less than that in the foregoing illus- 
tration. But, should the institution with the foregoing- 
pension system reach a maximum size and remain constant, 
for some time, the burden would come on to the extent of 
about one-sixth the entire budget. Furthermore, a decrease 
in size of faculty would increase the burden. With a. 
marked decrease in the size of the faculty, the increase of 
the burden might cause the loss of pensions altogether to> 
teachers who had paid for them two or three times the 
market value. 

It is natural for an institution to look forward to growth, 
and expansion. In the days when assessment insurance 
was in favor, the agent would declare that his particular- 
company was sure to grow rapidly, and that the constant; 
influx of young blood would keep the price of insurance: 
low. But a little reflection will show that most institutions 



Dangers in Establishing Pension Systems 13 

"will at some time reach a maximum size — at least, a maxi- 
anum for efficiency. And many institutions will show nu- 
merical decreases; some institutions may, indeed, deliber- 
ately sacrifice quantity for quality, in raising standards. 

Any process for computing insurance or pensions, which 
takes advantage of a postulated numerical increase, is un- 
sound. 

The proper pension reserve is the present value of all 
pension obligations due and accrued. With this reserve 
fund in hand, an institution can close its doors at any time 
or dispense with its pension system, giving complete satis- 
faction to all. This fund will buy pensions from insurance 
companies for those already pensioners, and will return to 
others their contributions with interest. Until the pension 
reserve fund, has been established, an employee's expectation 
of a pension is an act of faith. This faith seems well justi- 
fied — sometimes. 

§ 6. Preliminary Computations in Establishing A 
Pension System 

In the plan for pensions suggested by the Teachers Insur- 
ance and Annuity Association, the contributions made by 
or for the employees — 

(1) Are given the benefit of compound interest. 

(2) Are non-forfeitable. 

(3) Are used with their interest accumulations to pur- 
chase the form of pension desired — the benefit of compound 
interest again being granted. 

Another plan, which is fair as between employer and 
employees collectively, would eliminate the non-forfeiture 
provisions (2), and distribute among the survivors the 
funds of deceased employees. This would increase consid- 
erably the size of the pensions, while the cost to employer 
would be the same. This plan is perfectly sound actuarially. 
But its fairness may be questioned ; it borders rather closely 
upon objectionable speculation; and it is doubtful whether 
it gives protection as adequately as a plan with non-for- 
feiture provisions. 



14 University of Texas Bulletin 

In the detailed discussion of pensions in different cases — 
to be given presently — it will be assumed that contributions 
to the pension fund are non-forfeitable. 

The question as to whether the pension should be paid 
for (1) wholly by the employer, (2) wholly by the employee, 
or (3) in part by both, seems to belong to the realm of 
bookkeeping or psychology ; because money available to pro- 
vide for pensions would be equally available, in general, 
to provide for increases of salaries. 

Furthermore, the question is left open as to whether the 
pension funds (1) should be invested in the name of the 
employer, (2) should be left with a trust company, or (3) 
should be paid to an insurance company as premiums. 

If the employees of a corporation are all young, or if it 
may be assumed that the older employees have already made 
adequate or nearly adequate provision for their old age, the 
establishment of a pension system involves no special prep- 
aration. Starting with the current year, contributions may 
be made by an employee, or may be assigned to his account 
by his employer in proportion to his salary, and these are 
to be credited to him individually, and compound interest 
computed thereon for his benefit. When the time for his 
retirement comes he is to be assigned a pension which his 
accumulations will buy in accordance with a standard an- 
nuitant table (such as McClintock's) with interest — say at 
four per cent. 

But the establishment of a pension system is often con- 
fronted with the serious difficulty of providing pensions of 
considerable amount for the older men when no proper re- 
serve fund for the pensions immediately payable is on hand. 
If a pension program is started without first obtaining the 
requisite reserve fund a concealed deficit is created. The 
proper initial reserve fund, indeed, together with the later 
contributions and the interest derived therefrom would al- 
low all generations of employees to get pensions at proper 
rates. But, if this proper initial reserve fund is not created, 
the loss of interest thereon causes the younger generation 
to pay for their pensions about double their market value. 
And, furthermore, the burden thus put upon the younger 



Dangers in Establishing Pension Systems 15 

generation is augmented if salaries have arisen less rapidly 
than the cost of living. 

As a preliminary step for the establishment of an equit- 
able pension system, an examination of salaries and the cost 
of living for the preceding 35 or 40 years is to be recom- 
mended. 

With reference to providing adequate pensions for the 
older men, a discussion of the pension problem will be given 
now in four cases, based upon the degree of change of the 
salary scale and the cost of living. 

Case I 

To develop the most simple case first, suppose that neither 
the scale of salaries nor the cost of living has varied ap- 
preciably over a period of about 40 years prior to the time 
when the pension system is to be established. The reserve 
fund, and the pension system can be equitably established: 

(1) By declaring an increase — of say 10 per cent — on 
all salaries, past and future, of present employees. 

(2) By accumulating all the increases on past salaries 
for each employee at say four per cent compound interest, 
and crediting the individual pension account of each em- 
ployee with his total. This accumulation of an employee, 
together with any later additions with due credit for inter- 
est, determines the size of his pension. 

(3) By using the increases on future salaries just men- 
tioned as contributions to the individual pension accounts 
of each employee — the salary to be received in cash by each 
employee being undiminished. 

It is perhaps obvious that, inasmuch as no past salaries 
as actually paid have contributed to the pension reserve, no 
future salaries conforming to the same scale should con- 
tribute ; but that an additional percentage for pension pur- 
poses should be assigned to all salaries alike, past and fu- 
ture. It may be remarked that the solutions of the pen- 
sion problem, as outlined in this paper, are based solely upon 
mathematical equities, assigning equal benefits for equal 
service (counted in years) to men of equal ranP relative 



16 University of Texas Bulletin 

to their own generation. Moral equities and questions as 
to tvhat otipht to be done are not discussed. 

Case II 

The cost of living has increased steadily over a period 
of about 40 years, and the average salaries of the employees 
considered have kept pace with this increase — ^the employees 
being considered in their proper ranks or groups. 

A program essentially equitable to all is that of follow- 
ing the three steps under Case I, but in the second step, 
using a higher rate of interest suitably chosen. 

Suppose, for example, that four per cent is considered 
a normal rate of interest under Case I. Then the use of 
four per cent also in Case II would not give the older men 
their equitable share in the pension reserve; for a 10 per 
cent increase declared upon the salaries of 35 years pre- 
vious would not be comparable with a 10 per cent increase 
on recent salaries. 

But compound interest at five per cent for 35 years gives 
an amount about 40 per cent greater than compound in- 
terest at four per cent. If, then, the cost of living and the 
salary scale have both advanced 40 per cent in the 35 years, 
the use of compound interest at five per cent instead of 
four per cent would be an offset against the smaller salaries 
of earlier years. 

More delicate adjustments are possible. For example, by 
taking the cost of living in the current year as 1, the cost 
of living in another year can be obtained as a fraction — 
that is, an "index number" divided by 100. The fractions 
so obtained can be used as divisors upon the salaries of 
former years to obtain adjusted salaries for former years, 
and the 10 per cent retroactive increase can be declared 
upon the adjusted salaries. Thus if the cost of living has 
increased 40 per cent in 35 years, the index number for the 
thirty-fifth year previous would be 100/1.4^71, if the index 
number for the current year is 100. The corresponding 
fraction is .71. Dividing by .71 a salary of 35 years pre- 



Dangers in Establishing Pension Systems 17 

vious would increase it by 40 per cent. And a 10 per cent 
of this adjusted salary would correspond equitably to a 
10 per cent of a current or recent salary. But it is doubt- 
ful whether the gain in equity, by using the latter method 
rather than the first method described for Case II, is sub- 
stantial, because of uncertainties inherent in the index num- 
bers. 

With a changing cost of living and a changing salary 
scale, absolute equity is unattainable. Contributions of the 
present generation duly made and credited with interest 
may have their purchasing power curtailed by a further 
increase in the cost of living during the next 35 years. On 
the other hand, the purchasing power may be increased. 
After a pension system is once started, it is doubtful whether 
an attempt to make adjustments for a changing cost of liv- 
ing is advisable, as the chances for gain or loss in pur- 
chasing power of contributions may be about equal. But, 
at the start, when it is known that the cost of living has 
increased, and there is no chance involved, equity would 
seem to demand that the salary increments of earlier years 
be augmented properly by some method. 

Case III 

The average of salaries has increased over a period of 
about 40 years, but this increase has not kept pace with 
the cost of living. 

In this ease, a natural way of providing for the reserve 
is as follows : 

(1) Declare such fin increase upon salaries, past and 
future, that the new augmented salaries shall be equivalent 
to the earlier salaries in purchasing power; and, further, 
augment the increases on past salaries in the ratio of the 
cost of living today to that when the salary was paid. 

(2) Accumulate for the pension reserve fund the in- 
creases of past salaries, thus determined, with interest — 
say at four per cent. 

(3) If this does not create an adequate pension re- 
serve fund, declare a further increase on all salaries, past 



18 University of Texas Bulletin 

and future — perhaps an increase of three per cent or five 
per cent — and accumulate the increases of past salaries for 
the pension fund on an advanced interest rate — say five 
per cent. 

(4) From the future salaries, as determined by the 
foregoing, deduct about 10 per cent as contributions to the 
pension fund. 

To carry out steps (1) and (2) with great refinement 
would appear to require annual adjustments such as might 
be made with index numbers for salaries and for the cost 
of living. But an approximate method would seem pos- 
sible in some cases. Suppose, for example, that over 35 
years salaries have increased 40 per cent, and the cost of 
living 54 per cent. Then a $1,000 salary of 35 years ago 
corresponds to a $1,400 salary of today. But this $1,400 
must be increased by 10 per cent — that is, brought up to 
$1,540 — to enable it to purchase the equivalent of the 
former $1,000 salary. The most simple assumption — not 
universally realized, indeed — is that the excess of cost of 
living increase over salary increase is the result of gradual 
growth. We should expect the standards of 32 years ago 
to differ less markedly than those of today from those of 
35 years ago, so that perhaps an increase of one or two 
per cent in the salary of 32 years ago would have made it 
equivalent to the salary of 35 years ago in purchasing 
power. If, now, this increase of one per cent or two per 
cent in salary had been granted at that time, and the in- 
crease had been put out at interest, it would perhaps have 
been about comparable with a 10 per cent salary increase 
of todays-making allowance for the purchasing power. 

Thus, if a flat increase of 10 per cent is made on earlier 
salaries, and these increases are not further augmented, the 
result is about the same as that obtained by using smaller 
increases for the earlier years, and then augmenting them 
by compound interest. 

Without implying that the approximations are necessarily 
good, the following two steps are suggested as possible al- 
ternatives for (1) and (2) : 



Dangers in Establishing Pension Systems 19 

(1) On future salaries declare such a percentage in- 
crease that the new salary average will have the same ratio 
to the salary average of 35 years ago that the cost of living 
now has to that of 35 years ago. 

(2) For the pension reserve fund declare on all past 
salaries of present employees an increase of the same per- 
centage as used for future salaries; and use these increases 
as directly obtained — that is, without interest. 

These rules are simple, and will often lead to substantial 
justice. 

Case IV 

The salaries or wages of the group of employees under 
consideration have advanced more rapidly than the cost 
of living. 

For this case 

(1) Declare on each past salary of present employees 
a percentage of increase determined by the cost of living 
and that salary scale for the year in question. 

(2) Accumulate for the pension account of each em- 
ployee, individually, these increases of past salaries, with 
interest — say at four per cent. 

(3) If the pension fund thus created is inadequate, de- 
clare a further increase on all salaries, past and future, of 
perhaps three per cent or five per cent ; and for the pension 
fund accumulate the retroactive increases at an advanced 
interest rate — say five per cent. 

(4) From future salaries, as determined by the fore- 
going, deduct about 10 per cent ; and accumulate these con- 
tributions to the pension fund at compound interest — say 
at four per cent. 

For pensions under the four cases just enumerated, it 
is contemplated that the contributions to the pension 
fund are to be credited to the employees individually and 
are non-forfeitable. Upon the death of an employee, the 
contributions with interest accumulations go to his estate 
or to a designated beneficiary. Upon his withdrawal, his 
fund can be turned over to him in cash, or if the employer 



20 University of Texas Bulletin 

wishes to preserve the pension idea, the fund can be used 
by the employer to purchase from an insurance company 
a pension (deferred annuity) for the employee, or perhaps 
to purchase insurance on his life. 

In the program for each of the four cases, a retroactive 
increase of salaries is declared, in order to remove the 
deficit which would otherwise exist in the pension fund. 
It is difficult to make retroactive justice complete. The 
foregoing discussion has been concerned only with the equi- 
ties of employees present and future. If desired, some dis- 
tribution can be made to past employees or their families. 

For a specified form of employment there may be special 
conditions to be considered in connection with a pension 
system. It would appear advisable that the one in charge 
of a pension system or its establishment consult some books 
on investments and life insurance, such as : The Mathe- 
matical Theory of Investment, by E. B. Skinner; Life As- 
surance Primer, by Henry Moir; Practical Lessons in Act- 
uarial Science, by M. M. Dawson; Institute of Actuaries 
Text Book— Part I, by Ralph Todhunter— Part II, by 
George King. 

§ 7. The Creation and Investment of the Pension 
Reserve Fund 

The foregoing section has dealt with methods for deter- 
mining the size of the pension reserve fund, and the dis- 
tribution of it to the pension accounts of the employees, 
especially in those cases where no pension reserve has been 
formed for employees nearing the age when pensions are 
payable. 

Any guess as to the probable size of this reserve is likely 
to be erratic, because of great differences in the age distri- 
butions among different groups of employees. If an em- 
ployee has been on the same salary for 10 years, and each 
year 10 per cent of his salary has been set aside for the 
pension fund, his reserve would be the salary of one year 
with interest accumulations. If the group of employees is 
made up almost entirely of men who have served but a 



Dangers in Establishing Pension Systems 21 

few years, the pension reserve fund would be less than the 
salary budget for one year; but, if the majority of em- 
ployees have been in service a long time, the pension re- 
serve fund would be greater than the salary budget of one 
year. 

It is not necessary, of course, that the reserve fund be 
raised or created at one stroke, although this method would 
give added security to the interests of all concerned. The 
pension fund may be raised in installments over perhaps 
five or ten years, with due regard for compound interest. 

But it should be emphasized that this method is likely to 
result in injustice if care is not taken. If, as the older men 
are placed on the pension list, younger men are employed 
at smaller salaries, and no increases in salary are given to 
the intermediate men when these increases would naturally 
be due, these curtailments of salary, by postponed promo- 
tions, will "raise" a certain portion of the pension fund. 
While this scheme may help to put the pension on a sound 
actuarial basis, it obviously short-circuits justice. 

The pension reserve fund should be represented by in- 
vestments or securities which yield a fair annual return. 
It is not necessary, however, that this fund should be act- 
ually separated from the other funds of the employer. But 
the pension fund, as carried on the books, should be aug- 
mented each year on the basis of some such interest rate 
as four per cent. Circumstances might warrant the use 
of five per cent, or might necessitate a lower rate. 

Indeed, the employer may have the pension fund invested 
in his business — if the business is on a secure footing. But 
the pension fund should appear on his books as a liability, 
just as if he had borrowed this money from his employees 
collectively at four per cent. In this case, the employer 
may at any time dispense with the pension system alto- 
gether, paying to the active employees the deductions al- 
ready made from their salaries, with interest, and buying 
pensions for the pensioners from insurance companies; and 
the net assets, the total assets minus total liabilities, will 
be unaltered. 



22 University of Texas Bulletin 

If pensions have been promised to employees, it is an 
error in accounting to regard the pensions as future ex- 
pense items of which no immediate account is to be taken. 
The promises or contracts for pensions create an accrued 
liability, which should be recorded. 

Even if pensions are forfeited by death or withdrawal, 
some adequate pension reserve fund should be carried on 
the books as a liability. From mortality tables, an allow- 
ance can be made for deaths ; and, from the experience of 
the company or employer or from that of similar concerns, 
an allowance can be made for withdrawals. 

§ 8. Pensions Obtainable Through Insurance 

A pension can be purchased from the matured endow- 
ment of an endowment insurance. For about $220 an- 
nually, beginning at age 30, a man can be insured for 
$10,000 on an endowment policy maturing at age 65; and, 
if he lives to this age, he can purchase with the $10,000 
payable to him at that time a monthly pension of about 
$90, or he can purchase a monthly pension of about $45 
payable to him as long as he lives and a monthly pension 
of about $40 payable to his wife as long as she lives, if 
her age is also 65. For about $170 annually, beginning at 
age 30, a man can be insured for $10,000 on a tvhole life 
insurance policy ; and, if he wishes at age 65 to buy a pen- 
sion, he can use for it the cash surrender value at that 
time, about $5,300 by American Experience Mortality Ta- 
ble, with 31/2 per cent interest. Other forms of insurance 
have policy values available to purchase pensions. 

The foregoing shows, incidentally, that a salary of $2,220 
per year from ages 30 to 64 is worth a great deal more than 
a salary of $2,000 with promise of a pension of $1,000 per 
year beginning at age 65, forfeitable by previous death or 
withdrawal ; for with the extra $220 a man can provide 
for this pension and, in addition, carry $10,000 in life in- 
surance. Or, indeed, he may invest the $220 regularly so 
as to get four per cent interest net, and buy at age 65 a 
monthly pension of about $150. The latter method yields 



Dangers in Establishing Pension Systems 23 

the larger pension, but does hot protect his family quite so 
well. An employee should be careful not to set too high a 
value upon a pension which is forfeitable by death or with- 
drawal. 

If objection be made to a combined insurance and an- 
nuity plan on the ground that the money invested realizes 
often a low rate of interest, the reply may be made that some 
insurance is for most men an actual necessity, whether the 
interest rate be high or low. 

The Teachers Insurance and Annuity Association offers 
to college teachers insurance and pensions either singly or 
jointly. A higher rate of interest, viz., four per cent, is 
guaranteed when the fund for the pension is accumulated 
directly — that is, without reference to insurance. 

Insurance companies make provision in various ways for 
total disability, the inability of the insured to engage in a 
gainful occupation. The Teachers Insurance and Annuity 
Association maintains the insurance in this case without 
further payment of premiums. Some companies maintain 
the insurance in force at its full face value and also pay 
an annuity of about one-tenth the face of the policy di- 
rectly to the insured, in case of total disability, the charge 
therefor being about $2.00 per thousand at age 40. On a 
$10,000 policy, the insured would receive $1,000 annually if 
disabled. This form of policy gives complete protection — 
it protects the family of the insured; it also protects the 
insured in case he becomes disabled before his natural earn- 
ing period has expired; and it protects him in his old age, 
by accumulating an endowment or policy value which can 
loe used to purchase a pension. 

§ 9. Enquiries Preliminary to the Establishment of 
A Pension System 

In the establishment of a pension system, several ques- 
tions should be asked, the answers to which will depend upon 
the particular group of employees for which the pension 
system is designed. Inasmuch as money available for pen- 
sions is in general equally available for an increase of sala- 



24 University of Texas Bulletin 

ries — with proper adjustment for past salaries — ^the gen- 
eral question of pensions is a question of the advisability 
of postponing the payment of a portion of an employee's 
salary. The following questions may then be asked : 

1. Have the employees of the specified group in the past 
shown their inability to make provision for old age to such 
an extent that a large proportion of them have come to 
want or financial embarassment? 

2. Does it seem probable that if the employees were given 
the increase of salary directly, equivalent to the indirect 
increase of salary which the equitable establishment of a 
pension system would in general require, they would still 
fail to lay aside adequately for the future, even, if the em- 
ployees were given information as to what monthly contri- 
butions would be required to purchase pensions and certain 
forms of protection, and the need of protection were 
stressed ? 

3. If only a few employees come to financial distress — 
due in general to continued illness or special misfortune — 
can some provision be made for them, without the estab- 
lishment of a pension system? 

Granted that some pension system is desirable: 

4. Should provision be made for the families of em« 
ployees who die or for employees who withdraw? 

5. Should an employee have an option between having 
a portion of his salary laid aside for a pension and re- 
ceiving this portion in cash? 

6. Should an employee in special cases be paid his full 
salary ; for example, when buying a home on time, and pay- 
ing eight per cent on the outstanding debt? If a man puts 
$1,000 into a pension fund which is paying him four per 
cent, instead of cancelling a debt of $1,000 bearing eight 
per cent interest, he loses $40 a year with compound inter- 
est thereon. 

7. Should an employee be consulted concerning the in- 
vestment of his contributions to his pension fund ? Should 
a college teacher have the option of depositing his contribu- 
tions with the Teachers Insurance and Annuity Association? 



Dangers in Establishing Pension Systems 25 

8. Should the pension reserve fund — 

(a) Be held by the employer and invested in 

proper securities? 

(b) Be turned over to some bank or trust com- 

pany? 

(c) Be paid to an insurance company as premiums 

for annuities (pensions) or insurance on 
the lives of the employees? 

§ 10. Conclusion 

It is possible to establish a pension system which will be 
equitable to all employees, present and future, and will be 
a great blessing to them. Opinions will differ as to whether 
the money distributed as pensions would give a greater or a 
smaller benefit to the employees than if given them directly 
as salary when earned. This question should be considered 
with reference to the particular group of employees for 
which pensions are under consideration. 

It should be clearly understood that: 

1. A pension is a portion of salary, the payment of which 
is postponed. 

2. For a sound pension system, there must be a pension 
reserve fund which is the present value of accrued liabili- 
ties, created by the pension contracts. 

3. The establishment of a pension system, equitable to 
all concerned, usually requires some technical knowledge of 
mortality tables and compound interest. 

4. The establishment of a pension system without proper 
preparation is likely to make the younger generation and 
future generations of employees suffer the loss of interest 
increments on their pension contributions, thus making them 
pay for their pensions, indirectly through low salaries, about 
twice as much as the pensions are worth. 

5. The defects in certain pension systems, like the de- 
fects in assessment assurance, may lie concealed for 20 or 
30 years, only to result in hardships after 40 or 50 years. 
A pension system should be studied in its entirety. 



26 University of Texas Bulletin 

It has been the purpose of this paper to point out a few 
of the large features of pensions. A great many important 
matters have not been touched. At the end of Section 6 
will be found the names of a few books which will be of 
interest to those who wish to study the technical side of the 
subject of compound interest, insurance, and pensions or 
deferred annuities. 



iS'c^ 



